Currencies do not always behave as they should, and today's u.s. dollar is a good case in point. By all accounts the U.S. dollar should be on the ascendency, yet it has experienced a steady erosion over the past 12 months and continues to exhibit weakness compared to the other major currencies (Figure 1). The dollar defiesbasic economic principles and conventional wisdom.

Figure 1 US Dollar Index

Textbooks call for currencies to respond to comparative interest rates. However, as Figure 2 demonstrates, the spread between the US. 10yr Treasury yield and those of other major countries is quite wide, especially with respect to Japan (256bps) and Germany (213bps). In theory , these spreads should encourage monies flowing into the United States and , as a consequence, a boost to the U.S. dollar index. More to the point, with the anticipated future rate increases, as the Fed moves to normalize rates, one would expect that the dollar would be the preferred currency among its competitors.

Figure 2 Interest Rate Comparisons

Other factors that a textbook would lay out in favour of a higher U.S. dollar would be the relatively strong economic performance and a more favourable U.S. corporate tax regime. Finally, the heady stock market would provide additional support for the U.S. dollar index to outperform its peer group.

So, what is holding back the dollar from regaining its previous high water mark? One answer offered is that the Chinese and Japanese—who are the biggest holders of U.S.Treasuries—are looking to diversify into other major currencies. However, this argument does not hold up to data scrutiny, as both nations continue to run large current account surpluses with the United States and continue to participate in purchasing Treasuries with their surplus dollars. And, even if diversification were a stated policy of their respective central banks —which it is not—the process would be relatively slow and would not be apparent in the near term.